Application of Thermodynamics Entropy Concept in Financial Markets

Abstract

Entropy is a mathematically defined quantity that is generally used for characterizing the probability of outcomes in a system that is undergoing a process. It was originally introduced in thermodynamics by Rudolf Clausius (Philos Mag J Sci 40:122–127, 1870) to measure the ratio of transferred heat through a reversible process in an isolated system. In statistical mechanics the interpretation of entropy is the measure of uncertainty about the system that remains after observing its macroscopic properties (pressure, temperature, or volume). In this work, we attempt that the concept of entropy in thermodynamics be applied to financial markets. The main goal of this study is fourfold: (1) First we begin our approach through the concept of financial economics entropy. (2) Next we introduce the concept of entropy in economic systems. (3) Here we are exploring the interpretation of entropy in finance. (4) Then we extend the concept of entropy used in finance with standard economic utility theory by using of entropy and its maximization. (5) Finally, we construct the model of variance equilibrium under an entropy (financial) risk measure. And this paper ends with conclusion.